Lecture 1

Thinking Like an Economist

Reading
• Mankiw, Chapter 1 & 2

1
 Scarcity
Human wants are unlimited, but resources
are not, and therefore our society cannot
produce all the goods and services we wish
to have.

2
 Scarcity

Choice Competition

3
 Economics

The study of how society manages its

scarce resources

4
Microeconomics
The study of how households and firms make
decisions and how they interact in markets

Macroeconomics

The study of economy-wide phenomena,

including inflation, unemployment, and
economic growth

5
 The Economist as a Scientist
Economists:
- make use of scientific method to think analytically and
objectivity.
- through observation, develop theories to explain how a
complex, real world operates.
- built models based on their theories.
- test their models and theories by collecting and
analyzing real world data.
- make assumptions in their models to simplify the
complex world and make it easier to understand.
6
 Economic Models
Two of the most basic economic models include:

- The Circular Flow Model

- The Production Possibilities Frontier

7
 The Circular-Flow Model

The circular-flow model is a

simple way to visually show the
economic transactions that occur
between households and firms in
the economy.

8
 The Circular-Flow Diagram
Revenue Spending
Market for
Goods
Goods & Goods &
Services sold and Services
Services
bought

Firms
Households

Inputs for Labor, land,

production Market for and capital
Factors
Wages, rent, of Production Income
9
and profit
 The Circular-Flow Diagram

Factors of Production
- Inputs used to produce goods and
services
- Land, labor, and capital

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 The Circular-Flow Diagram
Firms
- Produce and sell goods and services
- Hire and use factors of production (i.e. labor,
land and capital (buildings and machines))

Households
- Buy and consume goods and services
- Own and sell factors of production
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 The Circular-Flow Diagram

Markets for Goods & Services

- Firms sell
- Households buy
Markets for Factors of Production
- Households sell
- Firms buy
12
 The Production Possibilities Frontier
[PPF]

The production possibilities frontier is a

graph showing the various combinations of
output that the economy can possibly
produce, given the available factors of
production and technology.

13
 The Production Possibilities Frontier
Quantity of
Quantity of computers the economy could possibly produce by
Computers
using all the available factors of production and technology
Produced
3,000 Production Possibilities Frontier
of an economy produces only two goods
– cars and computers

Quantity of cars the

economy could
possibly produce by
using all the available
factors of production
and technology

14 of
Quantity
0 1,000
Cars Produced
 The Production Possibilities Frontier
Quantity of
Computers
Produced
3,000 D

2,200
C
2,000 A
Production
possibilities
frontier
B
1,000

15 of
Quantity
0 300 600 700 1,000
Cars Produced
 Concepts Illustrated by the Production
Possibilities Frontier
 [Productive] Efficiency (point B vs. point A:
A represents efficient level of production.
B is inefficient in production – factors of
production and/or technology have not been
fully utilized
 Tradeoffs (pt. A [more cars but less PCs]
vs. pt. C [more PCs but less cars])
 Pt. D is not attainable giving the available
factors of production and technology
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 Concepts Illustrated by the Production
Possibilities Frontier
Quantity of  Increasing Opportunity Cost
Computers
Produced [represented by the slope of
3,000 PPF: bowed outwards /
concave to origin]. i.e. if the
economy wants to have an
additional unit of car, the
economy would need to give
up more and more computers.

17 of
Quantity
0 1,000
Cars Produced
 Concepts Illustrated by the
Production Possibilities Frontier
Quantity of  Economic Growth
Computers
Produced [represented by shifting
3,000 the PPF curve
outwards]. i.e. if the
economy obtains more
factors of production
and/or increase its level
of technology

18 of
Quantity
0 1,000
Cars Produced
 Two Roles of Economists

- When they are trying to explain the world,

they are scientists.

- When they are trying to change the world,

they are policymakers.

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 Positive versus Normative Analysis
- As scientists, economists make Positive statements.
Positive statements are descriptive. They are making a
claim about how the world works.

“Minimum-wage laws cause unemployment”

- As policymakers, economists make Normative

statements. Normative statements are prescriptive.
They are making a claim about how the world ought to
be

“The government should raise the minimum wage”

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 Why Economists Disagree

- They may hold different scientific judgments and,

thus, may disagree about the validity of a positive
statement about how the world works.

- They may hold different values and perception

and, thus, may disagree on a normative statement
about what policy should use and what the policy
can accomplish.

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 Ten Principles of Economics
How People Make Decisions

1. People face tradeoffs.

2. The cost of something is what you give up to
get it.
3. Rational people think at the margin.
4. People respond to incentives.
 Ten Principles of Economics
How People Interact

5. Trade can make everyone better off.

6. Markets are usually a good way to organize
economic activity.
7. Governments can sometimes improve
economic outcomes.
 Ten Principles of Economics

How the Economy as a Whole Works

8. The standard of living depends on a

country’s production.
9. Prices rise when the government prints too
much money.
10. Society faces a short-run tradeoff between
inflation and unemployment.
 1. People face tradeoffs.

“There is no such thing as

a free lunch!”
 1. People face tradeoffs.
To get one thing, we usually have to give up another
thing.
- Work vs. play
- Food vs. clothing
- Pollution vs. cheap goods
- Efficiency vs. equity

Making decisions requires trading

off one goal against another.
 1. People face tradeoffs.

Efficiency vs. Equity

- Efficiency means society gets the most

[quantity of products] that it can from its
scarce resources.
- Equity means the benefits of those
resources are distributed fairly among the
members of society.
2. The cost of something is what you give
up to get it.

You should consider the Opportunity Cost when you

are thinking of the cost of getting something.

The opportunity cost of an item is what you give up to

obtain that item. If you go to college, you are not only
giving up the tuition fee and the cost of textbooks, but
also the wages of a job as well as the leisure time you
may enjoy if you are not attending a college.
3. Rational people think at the margin.
People make decisions by comparing
marginal costs and marginal benefits
- You will spend an extra hour of study if the
additional benefits of study are larger than the
additional costs (less leisure, or benefits you will
give up by doing something else, watching TV).
- A company might decide to produce an additional
unit of a product if the marginal revenue from
selling the product is larger than the marginal cost
of producing the additional unit.
 4. People respond to incentives.
The decision to choose one alternative over another
occurs when that alternative’s marginal benefits
exceed its marginal costs!

The decision to choose an alternative may change if

the marginal benefits (positive incentives) or the
marginal costs (negative incentives) of the
alternative change.
 4. People respond to incentives.

- When the hourly wage rises, people may decide to

work longer hours (increase positive incentive).
- When tax on cigarette rises, people may decide to
smoke less (increase negative incentive).
 5. Trade can make everyone better off.

- People gain from their ability to trade with one

another.
- Trade between two countries can make each
country better off.
- Trade allows people to specialize in doing what
they do best and to exchange those goods and
services that they would rather let others to
produce.
 6. Markets are usually a good way to
organize economic activity.

- In a market economy, households decide what to

buy and who to work for.
- Firms decide who to hire and what to produce.
- Communist countries worked on the premise that
central planners in the government were in the
best position to guide economic activity.
 6. Markets are usually a good way to
organize economic activity.

- In a market economy, households and firms look at prices when

deciding what to buy and sell.
- Prices guide decision makers to reach outcomes that tend to
maximize the welfare of society as a whole.
- Central planners failed because they lacked the information that
gets reflected in prices when prices are free to respond to market
forces.
 6. Markets are usually a good way to
organize economic activity.
In his 1776 book An Inquiry into the Nature and
Causes of the Wealth of Nations, Adam Smith made
the observation that households and firms
interacting in markets act as if guided by an
“invisible hand” that leads them to desirable market
outcome.
7. Governments can sometimes improve
market outcomes.

Market failure occurs when the market

fails to allocate resources efficiently.
7. Governments can sometimes improve
market outcomes.

When the market fails (breaks down)

government can intervene to promote
efficiency and equity.
7. Governments can sometimes improve
market outcomes.

Market failure may be caused by an externality,

which is the impact of one person or firm’s
actions on the well-being of a bystander.
 7. Governments can sometimes improve
market outcomes.

Market failure may also be caused by market

power, which is the ability of a single person
or firm to unduly influence market prices.
 8. The standard of living depends on a
country’s production.

Standard of living may be measured in different

ways:
- By comparing personal incomes.
- By comparing the total market value of a
nation’s production.
 8. The standard of living depends on a
country’s production.

Productivity is the amount of goods and

services produced from each hour of a
worker’s time.

Higher productivity  Higher standard of living

8. The standard of living depends on a
country’s production.

Almost all variations in living standards are

explained by differences in countries’
productivities.
9. Prices rise when the government prints
too much money.

Inflation is an increase in the overall level of

prices in the economy.
- One cause of inflation is the growth in the
quantity of money.
- When the government creates large
quantities of money, the value of the money
falls.
10. Society faces a short-run tradeoff between
inflation and unemployment.

The Phillips Curve illustrates the tradeoff

between inflation and unemployment:

Inflation  Unemployment

It’s a short-run tradeoff!

 End of
Lecture 1

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